One perceived advantage of exchange traded funds (ETFs) over open-end mutual funds is their greater trading flexibility.
Many investors believe that there are also advantages in respect of ETF costs. Specifically, expense ratios, transaction costs, and tax efficiency.
As with trading flexibility, the potential advantages will vary between investors depending on their investing tactics. I will lay out the reality and you can decide if there is a benefit for you.
ETFs tend to have lower total expense ratios (TERs) than open-end index mutual funds that track the same benchmarks.
That is a fact.
Expenses Can Differ Between Funds
However, the difference between index fund expenses can vary to some degree. And when you include actively managed funds in a specific category, the differences can be substantial.
Consider the Standard & Poor’s (S&P) 500 stock market index as at November 11, 2010.
The S&P 500 is considered as part of the Large-Cap Blend investment style.
The average TER for funds in this category, which includes both actively managed and index funds, is 1.13%. If your fund generates gross returns of 8%, 14% of that performance will go to the mutual fund company. In this era of fluctuating returns, that is a fair amount to give up in performance. And remember, that is the average TER. Many are even higher.
If we drill down into S&P 500 open-end index mutual funds and focus on some popular funds, we can find much better TERs.
The Fidelity Spartan 500 Index Inv (FUSEX) has net assets of USD 38.4 billion and a TER of 0.10%.
The Schwab S&P 500 Index (SWPPX) has net assets of USD 10.0 billion and a TER of 0.13%.
The State Street Global Advisors SSgA S&P 500 Index Instl (SVSPX) has net assets of USD 1.4 billion and a TER of 0.18%.
And the Vanguard 500 Index Investor (VFINX) has net assets of USD 96.9 billion and a TER of 0.18%.
All these funds have significant assets under management and all have extremely low expense ratios as compared with the Large-Cap Blend fund average of 1.13%. And no that is not a typo, all these funds start out at a performance advantage of approximately 1.0% versus the “average” fund in the class.
ETF Expenses Should Be Lower
Now if we compare these specific funds to certain S&P 500 ETFs, we see even lower costs with the ETFs.
Of course, as with funds, different ETFs will have different TERs. You also need to compare ETFs as you do with funds. Some ETFs may have higher TERs than some funds. But, if you do proper analysis, you should find that a quality ETF for a specific benchmark will have a lower TER than a comparable index fund.
Probably the most well-known S&P 500 ETF is the “spider”, also known as the Standard & Poor’s Depositary Receipts (SPDR) S&P 500 ETF (SPY). This ETF currently has net assets of USD 80.6 billion and a TER of 0.09%.
If we look at the iShares S&P 500 Index (IVV), this ETF has net assets of USD 23.0 billion and a TER of 0.09%.
While the top index funds have reduced their costs over time, you still get a little cost saving with an ETF.
Keys to Remember
From this, I suggest you take away five points.
One, there is a significant variation in expense ratios between open-end mutual funds in any given investment category. This is true for both actively managed funds and index funds. Make sure you do some comparison shopping before investing. Giving up 1.0% or more in return due to expenses is not a prudent way to accumulate wealth.
Two, there is some variation between the TERs of even the lower cost open-end index mutual funds. It may not be substantial, but still compare between index mutual funds.
Three, while ETFs do currently have lower expenses than index funds, the gap has narrowed greatly in recent years. Do not automatically assume that you will save more money with an ETF over an open-end index fund. Depending on your investment tactics, you may not.
Four, TERs may vary between ETFs. While a top ETF should have lower costs than a top mutual fund, not every ETF may beat every index fund on cost. Make certain you choose wisely when selecting ETFs.
Five, cost minimization is crucial. But do not confuse that with getting value for your money. While an ETF may have the lowest expense ratios, there may be other factors that make open-end index funds preferable for your needs. Transaction costs are one such factor.
ETFs trade like stocks. There are no sales charges (i.e. loads) charged by the issuing company.
Conversely, open-end mutual funds may be subject to sales charges. Given the number of funds available, I would likely never recommend that anyone pay a load for an index fund. But be aware that they do exist and be careful about paying any loads.
If you avoid funds with sales charges, there should be no cost difference between an ETF and an open-end mutual fund in this aspect.
Although there are no loads for ETFs, all trades are subject to broker’s commissions when ETFs are bought or sold.
If you buy or sell open-end funds directly through the fund company, you will not pay a commission. You are also normally able to transfer capital between funds of the same family without charge. So, open-end funds might actually be cheaper to trade than ETFs.
In buying and redeeming funds directly through the fund company, transaction costs may be cheaper for funds than ETFs.
However, for convenience, many investors hold all their portfolio investments in one or two brokerage accounts.
If you use your brokerage account to trade open-end funds, you may be charged a broker’s commission similar to what is charged on an ETF. Every broker has a different pricing scheme, so review each for their commissions on ETFs and mutual funds. Also, many brokers have arrangements with certain fund companies so that commissions on some open-end funds are waived. That may also impact your costs.
Comparing Costs Can Be Tricky
Sometimes it is difficult to ascertain the true cost of transaction costs when trading through a brokerage account. Comparing ETF commissions is relatively easy, but evaluating potential open-end mutual fund costs is trickier.
For example, in the U.S. E*TRADE currently charges a flat-fee commission for on-line transactions of USD 9.99 for ETF trades. That fee falls to USD 7.99 if you trade at least 150 times in a quarter.
E*TRADE offers over 7600 open-end mutual funds and charges a broker’s commission of USD 19.99 for any no-load funds that are subject to transaction fees.
Of the offered funds, E*TRADE has over 1100 mutual funds on which it waives the USD 19.99 broker’s commission. However, reading the fine print, if you redeem any of these waived fee funds within 90 days from date of purchase, you will be charged an early redemption fee of USD 49.99. This is to discourage trading of commission-free funds.
In comparison, TD Ameritrade also charges a USD 9.99 flat-free commission on internet ETF trades. But TD Ameritrade has over 100 ETFs for which they waive the commission (subject to a 30 day hold requirement). Something not available at E*TRADE.
TD Ameritrade charges a internet flat-fee commission of USD 49.99 on its offering of over 13,000 mutual funds. Of these, TD Ameritrade has hundreds of mutual funds where the broker’s commission is waived. They also charge a short-term redemption fee of USD 49.99 should you redeem any of these funds within 180 days.
The ETF calculations are simple. Except for a few waived commission ETFs, you will generally pay USD 9.99 per trade at either E*TRADE or TD Ameritrade. Given that ETFs trade on exchanges, you should be able to buy any domestically traded ETFs. Depending on the brokerage house, you may have better, worse, or no access to international exchanges.
Other Factors Impact Your Cost Decisions
But with open-end funds, things are more complex.
First, different brokers are able to provide a different selection of mutual funds. While E*TRADE’s 7600 funds is a lot, you get almost twice the selection at TD Ameritrade. This might lead you to accepting higher transaction costs in order to have more investment options. The same is true with the selection of no-transaction fee funds.
Second, it you intend to buy and hold mutual funds, 90 or even 180 days might not be an issue to worry about early redemption penalties. But if you might want to be able to sell in under a half year, you might not be able to escape the commission.
Depending on where and how often you intend to trade mutual funds will dictate whether transaction costs are lower for open-end funds versus ETFs.
After all that, what do we have?
Keys to Remember
One, if you trade no-load open-end mutual funds directly through the fund company, they will be less expensive to trade than ETFs.
Two, if you trade open-end mutual funds through your brokerage account, they may or may not be less expensive to trade than ETFs. If you want maximum flexibility in selecting your investments, ETFs will have lower transaction costs than funds that do not have waived fees.
So yes, ETFs can have lower transaction costs. But you should be able to easily structure your affairs to offset this cost advantage.
Three, based on your investment strategy and tactics, you may decide paying slightly higher transaction costs is justified.
Four, brokerage houses like to make pricing complicated.
Another potential advantage of ETFs over open-end mutual funds is their tax efficiency.
It is often cited that taxable capital gains are only incurred when the investor sells an ETF. With mutual funds, the capital gains flow out to shareholders as the fund itself incurs gains on internal sales. As a result, shareholders may be liable for capital gains taxes even while they still own the mutual fund shares.
Of course, the relevancy of this advantage depends on the tax laws affecting you. I suggest you take a look at the jurisdiction applicable to you and determine what, if any, advantages ETFs may have over mutual funds in respect of taxes.
After all that it remains to be seen if ETFs truly provide cost advantages against major open-end index mutual funds in the same category. This runs contrary to conventional wisdom on the subject. Something I suspect arose back when fund costs were significantly higher.
So do not blindly assume that ETFs will be cheaper than all open-end index mutual funds.
Always compare costs before investing in one or the other.
And always factor in your how you intend to trade (e.g. via fund company versus broker, frequent trades versus buy-and-hold, etc.) as that will also impact your decision.